Canada’s proposed tax changes: Are they ‘smart’?

September 26, 2017

Two weeks ago, the Canadian federal government proposed changes to the taxation of private corporations. It proposes to amend what it deems some of the most prevalent and unfair tax avoidance methods including income sprinkling, holding passive investments in a private corporation, and surplus stripping. Since their announcement, the government has received considerable pushback against these proposed changes. There are indications that the government remains open for feedback.

Many of the changes align with the Institute’s smart taxation framework, while others do not. Since the rules are not yet locked in, it is hoped that this analysis will help inform the public discussion.

What is ‘smart taxation’?

A smart tax system should focus on three principles: effectiveness, efficiency, and equity in order to optimize the benefits that business activities provide to their owners and society as a whole:

Effective taxation supports activities that produce positive externalities, while disincentivizing negative ones. Positive externalities such as research and development investments occur at sub-optimal levels without government involvement because the individual firm cannot monetize the additional benefits to society. Similarly, negative externalities such as pollution should be discouraged through direct taxation.

Efficient taxation ensures distortions to the economy are minimized, spreads the tax burden over the entire tax base, and minimizes preferential treatment of specific groups.

Equitable taxation ensures those with the most ability to pay do so and that the tax rate increases with income earned (progressive taxation).

While effectiveness should always be maximized, there are often trade-offs between efficiency and equity. Governments must decide how to balance the two principles. The proposed tax changes tackle regulations that can cause business owners to make decisions that are not economically optimal in order to maximize the owner’s after-tax income. The Canadian tax system is based on the “theory of integration,” meaning an individual’s income should be taxed at the same rate regardless of whether it was earned as salary or corporate profits. In other words, there should not be a tax incentive to shelter income inside a business rather than deposit it into a personal account, or vice versa, in order to avoid paying tax. The proposed tax reform works to ensure this is the case.

Changes to Canada’s corporate tax rules

The federal government has proposed amendments to what it deems some of the most prevalent and unfair tax avoidance methods: income sprinkling, holding passive investments in a private corporation, and surplus stripping.

Income sprinkling

Definition: Income sprinkling is when the owner of a corporation pays a salary or dividends to family members in excess of their contribution to the business’s operation. The owner takes advantage of the tax-free basic personal amount and lower marginal tax rate of family members and therefore gains substantial tax savings compared to if the income was attributed to only the owner.

Proposed change:The removal of income sprinkling for corporation owners improves Canada’s taxation efficiency as it minimizes preferential tax treatment for a specific group (CCPC owners). Family taxation (income sprinkling) does improve taxation equity as it focuses taxation on a family’s ability to pay their tax. As expenses are shared between a family unit, and not an individual, the after tax income is what really matters to them. Re-implementing a form of family taxation available to all income earners would be a way to improve taxation equity, but would come at the cost of efficiency.

Holding passive investments inside a private corporation

Definition:When a business earns more money than the owner needs to withdraw for personal expenses there is an opportunity to leave profits within the corporation and invest it in passive income, such as stocks, bonds, or real estate, rather than productive activities. This action disrupts the ‘theory of integration’. The income being invested inside the corporation has been taxed at the much lower business rate compared to someone who is investing their personal after tax income. This leads to a larger principal investment being made, which compounds over time into a substantially larger sum. After only ten years, the after-tax interest income of the investment made within the corporation is 1.8 times that of the same interest earned outside. Additionally, by controlling when the income is paid out the corporation is being used as additional tax avoidance vehicle, like the TFSA and RRSP, which is not available to wage earners. Passive investment income can be withdrawn from the corporation and taxed when the individual’s marginal tax rate is at its lowest point.

Proposed change:To combat passive investments being utilized inside a corporation the Department of Finance is considering multiple options including implementing a tax on passive investments equivalent to the maximum federal personal income tax rate. This would discourage the use of the corporation as a personal investment vehicle as passive income always faces harsh taxation when being withdrawn. This change improves Canada’s taxation efficiency by removing benefits provided to only a subset of the population. Additionally, taxation equity improves as only individuals with significant wealth can afford to retain income inside a corporation.

Converting income into capital gains

Definition:Finally, the federal changes will target the conversion of corporate profit into capital gains, which have a lower effective rate—only 50 percent of capital gains are taxable—than income paid out as dividends or a salary. Owners of a corporation are also entitled to the lifetime capital gains exemption (LCGE) of $824,176. A problem arises when individuals not active within the business begin claiming the businesses income against their LCGE. This practice multiplies the intended effect of the exemption, shielding a substantial amount of wealth from due taxation. The curtailing of this practice will improve Canada’s taxation efficiency as the preferential treatment of CCPC owners will decrease.

Proposed change:The proposed changes will limit the ability for a corporation to distribute its surplus income to minors, trusts, employee profit sharing plans, and adult family members to utilize the LCGE. However, this causes problems for legitimate succession and estate planning among family members. A family member buying the current owner out to ensure proper family succession of the business will under the proposed changes face taxation on a dividend rather than the much smaller capital gain. The new rules could make it preferable for the company to be sold to a stranger rather than an arms-length family member. The Department of Finance should examine the impact of these regulations and find amendments that do not discourage family run corporations to persist across generations. The distortions created by this policy would decrease Canada’s tax efficiency.

Aligning the taxation of income from all sources will make for a more equitable and transparent business environment. If entrepreneurs require additional incentives to compensate for their risk then the government should provide tax and business incentives on the corporate income side that will not affect the owner’s personal income tax rate. A business that grows due to the reinvestment of profits should be the mechanism for owners to maximize theirs lifetime earnings rather than tax planning.